Introduction
Prior to the passage of the Bayh-Dole Act (the "Act") by Congress in 1980, inventions, writings and creations of American academic institutions were for the most part freely contributed to the body of public knowledge. In the 1980s, following the passage of the Act and influenced by diminished state funding and the examples set by a few successful institutions, American universities became sophisticated in protecting their intellectual property and began developing technology transfer practices. The 1990s have seen further advances, with American universities becoming far more aggressive and creative in their intellectual property strategies. This article briefly surveys three of the approaches used today by several American universities, with a focus on institutions (i) licensing their intellectual property to start-up companies, and (ii) enabling members of their faculties to launch companies to commercialize their technologies. This article highlights the pros and cons of each approach, and although both the Act and universities focus on licensing technology both to start-ups and to larger companies, this article focuses upon university licensing to start-ups.
The Bayh-Dole Act and Other Changes in the Academic Landscape
The Act was enacted at the end of 1980 as part of the United States Federal Government's initiative to stimulate technological progress and the commercial exploitation of the products of American government research funds. Before the passage of the Act, many academic institutions did not aggressively pursue intellectual property protection for their inventions. One reason for this was that many such inventions were created with the aid of federal funds, and the majority of the statutes which provided for federal funding for research mandated that the results be contributed to the public domain. Inventions created in pre-Act academia which were not the result of federal funding may also not have been patented because of the perceived high cost of obtaining patents, and the lack of specialized skills and knowledge at each institution to evaluate the advisability of patenting particular inventions and thereafter prosecuting patent applications. Additionally, prior to the Act, most institutions lacked clear policies on the sharing of licensing income with inventors, and thus inventors did not have a strong incentive to disclose their inventions.
The Act addressed these problems by setting a national policy regarding inventions which are created in the course of federally funded research. Essentially, the Act provides that the title to such inventions should remain with the funded organization that performed the research, and that such inventions should be patented and exploited, subject to certain limited exceptions and exclusions, such as "march-in rights", and the granting of confirmatory government licenses. March-in rights are rights reserved to the government to compel an inventor that is subject to the Act to grant licenses to third parties if the inventor is not diligently commercializing her or his invention. 1/ Confirmatory licenses are another requirement of the Act, which require inventors to grant to the federal government the right to use the invention. 2/
The central theme of the Act as it applies to American universities is to require such universities which receive public funds for research (i) to evaluate their technological advances, and if they so choose, to retain title to such inventions, (ii) if such organizations elect to retain title to its inventions, to protect such advances, if patentable, through the applications for patents, and (iii) to actively pursue the commercialization of any patents that cover such advances, especially through licensing or otherwise cooperating with small businesses in the United States. The Act also provides that universities must share licensing revenues with the inventors of each technology, respectively. In sum, the post-Act era has seen a remarkable shift in American universities' intellectual property strategies.
One direct result of the Act was that American universities developed technology transfer offices. Since the Act mandated that universities protect such a substantial number of potentially patentable inventions, it suddenly became more economical for such institutions to run these offices, which are staffed by people with the specialized skill sets to develop, manage and commercialize often large and complex intellectual property portfolios covering both those inventions which arise out of federally funded projects and those that were developed without such funds.
Additionally, since the time of adoption of the Act, the amount of funding provided by certain states to public universities has diminished. This has forced state universities to focus more closely on other sources of revenue generation, such as technology licensing. Several institutions have also demonstrated the ability to generate significant revenue from their research activities, which has in turn generated interest from their peer institutions. For example, the University of Florida receives substantial revenues each year from the licensing of its rights in Gatorade, which was originally created by scientists there. Additionally, according to the Report, licensing income to American universities in the 1996 fiscal year totaled $365.2 million, representing an 22.1 percent increase over the year before. These statistics, which demonstrate the potential for vast profits, have encouraged other institutions to invest in building their research capabilities as well as their technology transfer infrastructure.
Modern Licensing Approaches Applied in the Era of Bayh-Dole
One of the primary objectives of the Act was to encourage cooperation between federally funded research groups within non-profit organizations and federal agencies (although federal agency research results are not covered in this article) on the one hand, and small businesses on the other. The various approaches now used by universities, as licensors, to provide their technologies to start-up companies may be divided into three broad categories, although in actual practice, institutions usually find their own mix of the strategies. We shall refer to the three broad categories as "classic licensing", "equity licensing" and "the incubator approach". The classic licensing approach was the approach that was first adopted by American universities in the early 1980s; equity licensing and the incubator approach are newer, more creative strategies.
Classical Licensing
In a classic license transaction, the licensor receives royalties based on the sales or projected sales of the product which is covered by, or produced, using the licensed technology (a "Licensed Product"). Payments are usually broken up in varying degrees between up-front payments and ongoing payments based on actual sales or projected sales of Licensed Products. From the licensor's perspective, this structure is the most conservative, as the Licensor will usually try to negotiate a substantial payment up-front, and minimum annual royalties thereafter. Minimum annual royalties should theoretically be based upon the parties' estimate of the volume of sales that the parties reasonably believe will be attained. It should be noted that demands by universities for minimum annual royalties are a more recent addition to the classic licensing approach, and arose due to the fact that an exclusive license to a party who chooses not to commercialize the Licensed Product will both deprive the licensor of any potential royalty income and deprive the public of the opportunity to purchase the Licensed Product.
In the past as well as today, almost all universities practice this approach to licensing as their first choice when licensing out technologies. The classic licensing approach provides the licensor with a measure of predictability and assurance with respect to future revenues by giving the licensor certain payments, and the licensee's commitment to pay in the future, but prior to the completion of the product development cycle. In this way, the Licensor is essentially passing to the licensee the risk associated with developing the new technology. Such an approach benefits the licensor by providing the licensor with immediate cash benefits, and some speculative future upside if the product is successfully commercialized.
When this approach involves minimum annual royalties, it also has an additional benefit for the licensor of being a self-policing tool to assure the licensee's development and commercialization efforts. It does this by essentially punishing a licensee who is not diligent in commercializing the Licensed Product, because the licensee will have to pay the minimum royalties to the licensor regardless of whether the licensee has successfully brought the product to market. There is also a certain amount of institutional security and comfort in using such an approach. Finally, this approach requires far less diligence and management on the part of the licensor than do the other approaches discussed below.
From a start-up company's perspective however, such a structure presents several problems. First and foremost is the fact that, as the licensee, a start-up often does not have extensive amounts of capital, and to the extent that the licensed technology is not yet ready for market, the licensee would prefer to devote its financial resources to research and product development activities, rather than to paying minimum royalties and up-front payments to the licensor (in contrast, many of the larger and more established companies that choose to take licenses from a university are able to afford to make significant pre-commercialization expenses). Universities have appreciated this fact and have in turn come to consider alternative approaches.
As an example, Stanford, according to its web-site, in certain limited circumstances may consider licensing start-up companies on terms that include very little, if any, pre-commercialization payments in order to facilitate the start-up company's ability to develop and commercialize a technology. However, in such cases Stanford may request a higher running royalty on actual sales of Licensed Products. Additionally, in connection with the classic licensing approach as well as the other approaches discussed below, many institutions will allow potential licensees to take a "test-drive" of certain technologies, granting a license for a limited period so that the licensee can evaluate the technology. Such test-drives usually come with an option to obtain a full license after the licensee has "tried out" the technology.
While universities have recently widened their horizons and become more friendly to entrepreneurs and start-ups as licensees, they have also become more sophisticated and aggressive in their licensing practices. Some universities have become more focused upon setting development and commercialization milestones which toll payment obligations, and setting forth requirements for the licensee's diligent development of the Licensed Products. Some are also making efforts to limit the scope of licenses to certain fields-of-use, which allows more than one licensee to commercialize a single technology. This structure allows a university to maximize its licensing revenue and spread its risk among several licensees. Universities have also become more sophisticated in terms of royalty rates, often demanding higher rates, and setting staggered royalty rates. This provides a greater percentage of net sales to the licensor as the amount of sales increase, thus giving the licensor a share of the economies of scale achieved by the licensee.
Equity Licensing
The equity licensing model was developed as a creative solution to the key problem highlighted above for classic licensing: the requirement that the licensee make payments to the licensor prior to accruing revenues from the sales of Licensed Product. The equity licensing approach involves a grant to the licensor of an equity interest (shares of the start-up company's stock) in the start-up company in partial consideration for the grant of the license. Usually, such a grant of stock will be in addition to the ongoing responsibility to pay royalties to the licensor on actual sales of Licensed Products. One can therefore view the grant of stock as a substitute for some or all of the pre-commercialization payments that the licensee might otherwise have been forced to pay.
This approach has many advantages to both the licensor and to the licensee. The equity licensing approach is advantageous in the short run due to the licensee's increased ability to immediately devote its resources to taking what is often an early stage technology, and performing the further development work that is required in order to transform it into a commercial product. Also, the licensee may reap the benefits of commercializing the product sooner, and the licensor may see both royalties on the sales of the Licensed Products, and the appreciation of the licensor's equity interest in the start-up company, as well as any dividends which could be paid out from the company as profitability is attained.
The equity licensing approach has another advantage for both of the parties to the transaction, in that the equity approach has the effect of more fully aligning the interests of the parties. In the classic licensing approach, the licensor will be most closely focused upon the commercialization of the Licensed Product, and the royalties or other payments related to the license. Thus a licensor may pressure the licensee into taking actions which may benefit the licensor in the short term, possibly at the expense of both parties' long term interests. Under the equity licensing approach, however, this is less likely to occur since the licensor has a financial interest in the overall success of the licensee.
While the equity licensing approach has certain advantages, it also has certain disadvantages. First, the licensor will have to perform a far greater amount of due diligence on the licensee in order to attain a comfort level high enough to forego a cash payment in favor of an equity interest in the licensee. In particular, the licensor will need to obtain a high degree of confidence in the members of management and the board of directors of the start-up company. This is in contrast to the situation in a classic licensing context in which a university may be comfortable granting a license to an unknown entity if the up-front payments are sufficiently favorable. The reason for this difference is that in the equity licensing context, the licensor is gambling to a greater degree on the abilities of the licensee, since the equities have value only to the extent that the company's management is able to make the company successful in the future.
Another problem with the equity licensing approach is that unlike cash income, which is liquid, and susceptible to definitive valuation, equities, particularly equities in privately held start-up companies, are neither liquid nor capable of definitive valuation. Thus, such equities cannot be used immediately by the university to offset its costs, such as for patent prosecution and maintenance. Additionally, stock transactions are quite complex as they are subject to an expansive and complicated body of state and federal securities laws. This is particularly relevant for universities which have not previously received stock in connection with a licensing transaction, since the university will be forced to become educated as to compliance with such laws. In subsequent equity transactions, however, the university will be able to leverage the knowledge and possibly some of the documents it used in previous deals. At some institutions, separate legal entities have been established to hold the stock from these types of arrangements, with such steps requiring further administrative overhead for the institution.
According to their web sites, as examples, some variations upon the equity licensing approach are used at the following institutions: Harvard University, University of Michigan, and M.I.T. M.I.T. has been particularly successful in their out-licensing activities using both the classic approach as well as its own variation on the equity licensing approach. For example, according to its web-site, in the 1997 fiscal year, eight start-up companies were founded based on M.I.T. technologies, and the institution received $21.2 million in revenue from its licensing activities, including $5.8 million in equities.
The Incubator Approach
A third approach to commercializing federally funded university research results is the incubator approach. This approach involves the founding and support of start-up companies or virtual companies by the institution, and often also involves a technology transfer. According to an article in the December 15, 1997 issue of BusinessWeek, of the roughly 550 business incubators in the U.S., 13% are run by or in conjunction with a university. Incubators usually provide space for offices and laboratories and may provide some level of funding and administrative support to help the start-up or virtual company get off the ground. Such support may also include assistance in the development of a business plan, help in obtaining venture financing, and business counseling services. One example of a university which has actively used the incubator approach is Columbia University which, according to the October 20, 1995 Columbia Record, in cooperation with New York City and the State of New York, has recently developed a $28 million biotechnology incubator complex in the Washington Heights section of New York City. As with the Columbia University project, incubators often involve a cooperative effort between an academic institution and state or federal government agencies.
The incubator approach has many advantages, one of the greatest being that by keeping a given technology within the institution for a greater portion of the development process, the institution substantially increases the value of the technology, and hence the potential payments it may receive for such technology. Additionally, since many inventors in the academic world have neither the capital nor the business expertise to successfully start up their own technology companies, the advice and financial support of a business incubator can make the difference between success and failure for a given technology.
At the same time, incubators within the university context also have several inherent difficulties, including potential conflicts of interest for the inventor. Often in this context, an inventor will seek to maintain both a research position within the university while also running the virtual or start-up company. In such a situation, the inventor will have both fiduciary obligations to her company, and similar obligations to her employer, each possibly conflicting with the other. Such situations can be particularly difficult where the inventor makes subsequent inventions to which both the company and the university may make claims. There is also the practical issue of the inventor's time being a limited resource for two highly demanding jobs.
Finally, the incubator approach may involve the vesting in the university of a substantial equity interest in the virtual or start-up company. This may give the licensor some representation on the board of directors of the licensee. Such representation may itself raise conflict of interest questions, and will additionally require the licensor to devote a substantial amount of its time and resources to serving such obligations. Even without board representation, the management of an equity interest in a start-up company often requires a greater degree of attention than would a simple cash payment which might be received by a university under the classic licensing approach, especially because of the federal and state securities laws to which such equity interests are subject.
Conclusions
Over the past two decades, several factors have led to a substantial rise in technology development and transfer at American Universities. Chief among them was the passage by Congress of the Bayh-Dole Act which allows and encourages federally funded research institutions, universities among them, to protect the intellectual property rights to their inventions, to retain ownership of such rights, and to actively commercialize such rights, particularly in connection with small businesses. As a result of the Act and the lessons that universities have learned in the post-Act era, such universities have become sophisticated, and far more entrepreneurial in their approaches to transferring technologies to the private sector. The results of the past decades have been substantial, seeing fast growing profits for the universities themselves as well as greater accessibility to university developed technology for start-up companies.